Long Call Butterfly

Long Call Butterfly

Post By - Laxmi Mahera
Review By : Rohan Sharma
Updated on : October 26, 2021

Basics Concepts – Long Call Butterfly

Description – Long Call Butterfly

The Long Call Butterfly involves a low strike long call, two ATM short calls, and an OTM long call.
The resulting is profitable in the event of range bound action by the stock.
Although the risk/reward ratio is attractive, the problem is that the maximum reward is restricted to the scenario where the stock is at the middle strike at expiration.
Long butterflies are quite popular because they offer a good risk/reward ratio, together with low cost.
Buy one lower strike (ITM) call.
Sell two middle strike (ATM) calls.
Buy one higher strike (OTM) call.
All options share the same expiration date for this strategy.
For this strategy, you must use all calls.
Remember that there should be equal distance between each strike price.
The maximum reward occurs if the stock is at the middle strike at expiration.

Context - Long Call Butterfly

Outlook

With Long Call Butterfly, your outlook is direction neutral—you are looking for no movement in the stock.

Rationale

To execute a direction-neutral income strategy for a net credit while expecting a future decline in volatility.
Ideally you are looking for a scenario where the immediate Implied Volatility has been high, giving you above average options premiums, but where you anticipate the stock to consolidate (become less volatile) and remain range bound for the duration of your trade.

Net Position

This is a net debit trade, although the net cost is typically low.
Your maximum risk is the net debit of the bought and sold options.
Your maximum reward is the difference between adjacent strike prices less the net debit.

Effect of Time Decay

Time decay is helpful to this position when it is profitable an harmful when the position is unprofitable.

Time Period to Trade

Month or Less

Breakeven Down = [Lower Strike + Net Debit]
Breakeven Up = [Higher Strike – Net Debit]

Steps to Trading a Long Call Butterfly

Steps In

Try to ensure that the trend is range bound and identify clear areas of support and resistance.
Try to ensure that no news is coming out soon for the stock.

Steps Out

Manage your position according to the rules defined in your Trading Plan.
If the stock veers outside your stop loss areas above or below the stock price, then unravel the entire position.
You can unravel the position just before expiration—remember to include all the commissions in your calculations.

Exiting the Trade - Long Call Butterfly

Exiting the Position

With this strategy, you can simply unravel the spread by buying back the options you sold and selling the options you bought in the first place.
Advanced traders may leg up and down or only partially unravel the spread as the underlying asset fluctuates up and down.

Mitigating a Loss

Unravel the trade as described previously.
Advanced traders may choose to only partially unravel the spread leg-by-leg and create alternative risk profiles.

Advantages and Disadvantages

Advantages

Profit from a range bound stock for very little cost.
Capped and low risk.
Comparatively high risk/reward ratio if the stock remains range bound.

Disadvantages

The higher profit potential comes with a narrow range between the wing strikes.
The higher profit potential only comes nearer expiration.
Bid/Ask Spread can adversely affect the quality of the trade.

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